Real Causes of the Financial
Crisis
Philip Booth
Editorial and Programme Director, Institute of
Economic Affairs
Professor of Insurance and Risk Management,
Cass Business School.
Monetary policy and the crash
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Fed Funds Rate was cut from 6.25% to 1.75% in
2001.
It was cut further and held at 1% until mid 2004.
The real Fed Funds Rate was negative for two-anda-half years in the period 2002-2004.
A Taylor Rule would have led to a Fed Funds Rate
between 2% and 5% during 2001-2005.
Money supply was growing rapidly at 14.1% per
annum in September 2007.
Reinforcing moral hazard
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Fannie Mae had a commitment to spend $2trillion
expanding home ownership amongst low-income
earners and minorities.
40% of loans Fannie Mae bought and securitised in
2007-2008 were sub-prime, or Alt-A loans
Weak personal bankruptcy law
The absence of proper risk premiums in deposit
insurance systems
Continual bailing out of the US financial system (savings
and loans in the 1990s, LTCM, and so on).
“Greenspan put”
Unintended consequences of regulation
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Community Reinvestment Act
Encouragement of floating rate mortgages
Basel capital requirements and the ratings
agencies
US response to Basel capital requirements
Institutionalising systemic risk – the Basel
Accord
Tax and equity capital
Public choice
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Regulation can be driven by incentives bureaus:
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Regulators may discharge their duties by “writing
rules”
They will try to ensure that “something is done”
They will be risk averse, trying to reduce the number
of failures on their watch
If a failure does happen, the regulator may be
slow to act in the hope that recovery will happen
Regulatory capture
What should we do?
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Risk-based deposit insurance
Make depositors senior creditors
Living wills
Other legal mechanisms to ensure orderly failure
Banks should publish more detail of their
exposures to the market
Contingent capital
Reform equity taxation
Capitalism requires orderly failure!